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The originate-to-distribute mortgage securitization system that is in use in the United States has been blamed, in part, for the current financial crisis. The conventional analysis is that it does not require mortgage originators or distributors to share any of the underwriting risk, and thus creates moral hazard as bad
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mortgages are passed along to subsequent purchasers in the distribution chain. In seeking alternatives to the current system, the Treasury Department and the FDIC have both praised a covered bond system--in which banks continue to hold mortgages in a segregated account on their own balance sheets--that has been used widely in Europe. Although that system has not fared well in the financial crisis, a somewhat different covered bond system used in Denmark over several centuries has not been significantly impaired, despite the fact that the housing bubble in Denmark--which was proportionately larger than the one in the United States--also deflated. In this conference, we will review the characteristics of the Danish system that have helped Denmark survive financial crises for over two hundred years, and consider whether any of the elements of the Danish system can be useful in the United States.
| 9:45 a.m. |
Registration |
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| 10:00 |
Introduction: |
Peter J. Wallison, AEI |
| 10:15 |
Presenter: |
Alan Boyce, Absalon |
| Discussants: |
Bert Ely, Ely & Co. |
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| Olivier Hassler, World Bank |
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| Alex J. Pollock, AEI |
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| Moderator: |
Peter J. Wallison, AEI | |
| 12:00 p.m. |
Adjournment |
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WASHINGTON, APRIL 3, 2009--Although members of Congress and the Obama administration have sweeping ideas for how to regulate the U.S. economy in the future, few of them seem to have thought very deeply about how we finance mortgages, AEI's Peter J. Wallison said at a conference on March 26. "Yet, at the root of the country's current financial crisis is a dysfunctional mortgage system," he added. Although Congress's attention is focused on other economic issues now, Wallison convened a panel of experts to discuss structural reforms that might improve the broken U.S. housing market. Panelists discussed the relative merits of the Danish mortgage system, which, Wallison explained, "is attractive because it does not involve any explicit or implicit taxpayer liability, permits homeowners to take advantage of declines in the housing values . . . and appropriately separates interest rate and credit risk."
This separation of risk is a key aspect of the Danish system, explained Alan Boyce, the CEO of Absalon, because it properly aligns the incentives of the lender and the borrower. In Denmark, the credit risk of a loan is required to remain with the brokers or mortgage bankers who originated the debt. Unlike the current U.S. model, Danish mortgage originators are now invested in the credit worthiness of the loan; their interests become "perpetually aligned" with the borrowers, and they become de facto "liability advisers." The interest-rate risk in the loan is sold to bond holders.
When house prices fall, the Danish system's rules for refinancing--known as the Principle of Balance (POB)--have helped to mitigate the problem of negative equity. In the United States, Boyce explained, "even though the [market] value of the mortgage has dropped, the homeowner still owes the face value of the mortgage"--the value when the borrower bought the house, less any principal paid to that point. In contrast, in Denmark, a creditworthy homeowner can refinance his mortgage at the current market price, which can be lower than the unpaid principal value of the mortgage. This system helps the borrower maintain equity in his home. Boyce observed that although Denmark experienced the same housing bubble as the United States, "it did not lead to the [same] wave of foreclosures and defaults." A final benefit of the Danish system is its extreme transparency--all details of the mortgage system are published daily by the national exchanges, as well as by NASDAQ, so their market does not suffer from informational advantages like those of the United States.
To implement this system in the United States, Boyce detailed several of the changes that would have to be made to the current structure:
- Fannie Mae and Freddie Mac should only function as POB guarantors
- Credit risk allocation must be shared between the originator and the federal guarantor
- Borrowers could refinance their loan based on the market value of the mortgage
- All new mortgage loans would have full recourse
- A single prudential regulator would govern the entire system and would have the power to remove bad loans, bad brokers, and bad borrowers from the system and to raise capital and reporting requirements as necessary
Panelists' reactions to Boyce's proposal were mixed. Bert Ely of Ely & Co. noted that "negative equity [is] less of a problem in a mortgage system which does not produce bubbles and busts." He worried that the plan did not address the underlying instabilities of the U.S. housing market. Ely also observed an asymmetry in the POB system that favors the borrower. When interest rates rise and house prices fall, the borrower benefits from refinancing, but when interest rates fall and house prices rise, the lender cannot reap any similar benefits. An additional criticism was that the system encourages "serial refinancing," which would lead to higher transaction costs. Ely was also concerned that "the mortgage credit risk will be [too] highly concentrated in the mortgage credit intermediaries."
Another consideration, highlighted by AEI's Alex J. Pollock, is that many banks may be too small to function in this system and would be put out of business. Pollock pointed out that the Danish system is not perfect--Denmark suffered a housing bust in the early 1990s and is in the midst of a severe recession. A final problem, cited by the World Bank's Olivier Hassler, is that "there is a problem of introducing new financial instruments into this market. . . . Market acceptance is dependent on what the benefits and incentives will be for all of the market players." Hassler questioned whether the regulatory and legal frameworks in the United States could be sufficiently altered for the Danish system to work here.
Despite the panelists' many concerns, they had strong praise for certain aspects of the Danish system. Ely applauded the requirement of high down payments, since such a condition forces borrowers to have more skin in the game than many U.S. borrowers. Both he and Pollock cited the obligatory full-recourse loans as a particular strength. In the United States, mortgage loans are typically nonrecourse, meaning that defaulting borrowers are not responsible for paying the difference between the market value of their home and the principal amount of their mortgage loan. This difference in value is known as a "deficiency," and in Denmark, Pollock explained, "the deficiency is pursued until it is paid"--even if the payment can't be made for a decade or more. "The best element of the Danish mortgage system," he continued, "is that the mortgage originator is responsible for credit risk for the life of the loan. . . . With statistical regularity, mortgages that are produced by depository institutions, such as banks and S&Ls, performed better than all others. . . [because] credit risk remained on their portfolios."
--KAREN DUBAS
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Alan Boyce is the chief executive officer of Absalon, a joint venture between George Soros and the Danish financial system that is assisting in the organization of a standardized mortgage-backed securities market for Mexico. He is also the president of Adecoagro, a food and renewable energy producing company that owns and operates more than 270,000 hectares of highly productive land throughout Argentina, Brazil, and Uruguay, and a consultant for Soros Fund Management, where he works to implement the Danish mortgage system in the United States. Previously, Mr. Boyce was the senior managing director for investment strategy at Countrywide Financial Corporation, where he was responsible for secondary markets, the hedging of mortgage servicing rights, and the balance sheet for Countrywide Bank and Balboa Insurance. Mr. Boyce was the director of special situations at Soros Fund Management from 1999 until early 2007, where he managed a portfolio of assets of the Quantum Funds and had principal operational responsibilities for the bulk of the Fund’s investments in Latin America. Before joining Soros Fund Management, Mr. Boyce served for fourteen years as the managing director in charge of fixed income arbitrage with Bankers Trust. Prior to that, he worked for the Federal Reserve Board in Washington, D.C.
Bert Ely is a financial institutions and monetary policy consultant at Ely & Co. in Alexandria, Virginia. He has specialized in deposit insurance and banking-structure issues since 1981. In recent years, Mr. Ely has researched and written extensively on government-sponsored enterprise issues; coauthored an AEI monograph describing how to privatize Fannie Mae and Freddie Mac; and developed proposals for fundamentally reforming U.S. housing finance, specifically through the use of covered-bond financing for mortgages and a mortgage-product innovation that eliminates mortgage-refinancing costs. In 1986, Mr. Ely was one of the first to publicly predict a taxpayer bailout of the Federal Savings and Loan Insurance Corporation.
Olivier Hassler has been a senior housing finance specialist at the World Bank since 2001, where he coordinates the team of housing finance experts within the financial- and private-sector development vice presidency. He has been involved in projects, technical assistance, or analytical work in numerous countries in South Asia, Africa, the Middle East, North Africa, and Latin America. Previously, Mr. Hassler worked for a French financial institution that specialized in mortgage finance-especially for lower-income households-and municipal finance. He was in charge of funding and capital markets operations and had responsibilities in regulatory issues and real estate portfolio management.
Alex J. Pollock has been a resident fellow at AEI since 2004, focusing on financial policy issues, including government-sponsored enterprises, retirement finance, housing finance, corporate governance, and accounting standards. He has written extensively on the housing bubble and bust and is the author of the one-page mortgage disclosure proposal. Previously, he spent thirty-five years in banking, including twelve years as president and chief executive officer of the Federal Home Loan Bank of Chicago, while also writing numerous articles on financial systems and management. He is a director of Allied Capital Corporation, the Chicago Mercantile Exchange, the Great Lakes Higher Education Corporation, and the International Union for Housing Finance and chairman of the board of the Great Books Foundation.
Peter J. Wallison holds the Arthur F. Burns Chair in Financial Policy Studies at AEI, where he codirects the Institute’s program on financial market deregulation. He previously practiced banking, corporate, and financial law at Gibson, Dunn & Crutcher in Washington, D.C., and New York. From June 1981 to January 1985, Mr. Wallison was general counsel of the U.S. Treasury Department, where he had a significant role in the development of the Reagan administration’s proposals for deregulation in the financial services industry. He also served as general counsel to the Depository Institutions Deregulation Committee and participated in the Treasury Department’s efforts to deal with the debt held by less-developed countries. During 1986 and 1987, Mr. Wallison was White House counsel to President Ronald Reagan. Between 1972 and 1976, Mr. Wallison served first as special assistant to Governor Nelson A. Rockefeller and, subsequently, as counsel to Mr. Rockefeller when he was vice president of the United States.
